ICRIER

Economic Reforms

How Far Have We Traversed Between 1991 and 2012?*

Honourable Prime Minister, Dr Ahluwalia, Shri Ninan, Prof Raghuram Rajan, and friends:

The Prime Minister

History tells us that modern democracies have rarely had the good fortune of coming close to the Platonic ideal of being led by a Philosopher-King. We all know that economics draws its origins from moral philosophy. In fact, Adam Smith was a moral philosopher. Yet few economists since Smith have been viewed as philosophers. We are singularly privileged that we have in our Prime Minister a 'Philosopher-King' in the Platonic mould.
Speaking at this Festschrift to honour the Prime Minister is a very special occasion for me.
Those of you who have an exposure to the history of science would know that Sir Isaac Newton was an intellectually arrogant man. When his friend and rival Robert Hooke wrote to him, lauding him for his Theory of Gravity, Newton, for all his arrogance, wrote back with uncharacteristic humility:

"If I have been able to see a little farther than others, it is because I am standing on the shoulders of giants."

*Edited transcript of comments by Dr. DuvvuriSubbarao, Governor, Reserve Bank of India at the Panel Discussion on the book "India's Economic Reforms and Development: Essays for Manmohan Singh" in New Delhi on April 14, 2012.
That is a statement I can relate to. As the Governor of the Reserve Bank in these exciting times, I owe an intellectual debt of gratitude to the several extraordinary men who led the Reserve Bank through a variety of challenges. The most distinguished in that galaxy is Prime Minister Dr Manmohan Singh. I am proud and privileged to be in the same lineage.
Also, I was a junior officer in the Ministry of Finance when Dr Manmohan Singh came in as the Finance Minister in 1991. My tribute to Prime Minister Singh is, therefore, both personal and professional.
Standing in front of all of you, I am bewildered; also humbled. Frankly, I must confess I feel a bit foolish. However, I am reminded of what Prime Minister Singh once said, at another time in another context. When he thought he himself did something presumptuous, Raul Prebisch had told him, "in life it is sometimes wise to be foolish". I have been quite foolish in accepting this commitment to speak here. The wisdom of doing so is not yet clear to me. I hope, Sir, you will understand this temptation on my part to be foolish, and indulge in me even if I may have been unwise.

Economic Reforms 1991 and 2012
Since this festschrift is also a celebration of our reforms, of India emerging on the global scene, what I thought I would do is to raise a few questions straddling 1991 and 2012 in order to understand how far we have traversed, and also to highlight our current concerns.

Why 2012 is Not 1991?
The first question I want to raise and answer is, "Why 2012 is not 1991?". The reason I am raising this question is because a few people are beginning to ask the converse of this question. What they ask is the following: "Is 2012, 1991 all over again?"
The argument goes as follows. The 1991 crisis was triggered by balance of payments pressures which, in turn, were a consequence of the fiscal profligacy of the 1980s. We do have twin deficits once again. Since large fiscal and current account deficits are lead indicators of stresses building up in the system, is it just a matter of time, they ask, before we see an implosion once again?

To set this question in context, let me do a quick comparison of some macro indicators in 1991 and 2012.

Selected Macro Indicators

	1991	2012
Fiscal Deficit (per cent of GDP)	7	5.9
Current Account Deficit (per cent of GDP)	3	3.6+
Short-term debt/ Total debt (per cent)	10.2	23.3

These numbers present quite a disturbing picture. Nevertheless, I would still argue that in 1991, an implosion was imminent; but in 2012, an implosion is not imminent. Here are my reasons:
1. The structure of the economy has changed in fundamental ways.
2. Our financial markets are more mature, more diverse and much deeper. They have the resilience to absorb shocks.
3. Our regulatory systems and our crisis response mechanisms are more robust and more sophisticated.
4. The dominance of services sector in economic activity is also a source of resilience. The GDP share of services in 1991 was 41 per cent, that has increased to 65 per cent in 2012. The performance of the services sector is less variable than that of agriculture and industry, and therefore a source of resilience.
5. Fiscal deficit last year, at 5.9% in FY12 was high. But if we look at the years before that, it is a different story. By contrast, we find that fiscal deficit was above 7% in each year from 1985 to 1991. Also, today’s fiscal deficit is not entirely structural in nature. Because of the global financial crisis, it was necessary to make a policy induced deviation from the FRBM path.
6. Growth has taken a hit, in part, because of the financial crisis denting revenues. That has in turn increased the borrowing requirement.
7. The Current Account Deficit (CAD) is high because of high oil prices, and gold imports. Gold imports themselves are a result of people hedging against inflation.
8. In 1991, we had bottomed out on reserves. Today, our forex reserves are much larger - both in terms of months of import cover (2 months versus 8 months). Also external debt as a proportion of GDP was 1400% in 1991 as against 115% in 2012).
For all of the above reasons, in 2012, we are unlikely to see a repeat of 1991. I want to emphasize that I am only making a limited point that we are unlikely to see an implosion. I am not saying that we have insulated ourselves from all crises for all times, or that the economy is in the pink of health or on a roll. Or, indeed, that today’s macroeconomic situation is not a cause for concern.
On the contrary, there are serious concerns about our macroeconomic management, policy environment and governance. Far from being complacent, we should be agitated about the current state of the economy and about its prospects under a "business as usual" case.
People cite the India Growth Story as a source of optimism. Yes, the India Growth Story is a great one, but there is nothing inevitable about it. If the promise of that story materializing keeps diminishing, the story itself will gradually ebb away. We should prove that the current downturn is just a short-term phenomenon, and that our long-term growth drivers will come back into play. As for what we should be doing, the agenda is well known. Besides, I have no comparative advantage in putting it forward. In any case, Raghu who spoke before me, has very comprehensively indicated that. I can hardly presume to add value to that.
As I leave this question, I want to emphasize once again that in 2012, a 1991 type of implosion is unlikely. But there is no room for complacency. We need to take a lot of corrective action to rebuild the India Growth Story.

Have We Been Too Timid on External Sector Liberalization?
Let me now turn to my second question. "Have we been too timid on external sector liberalization?"
External sector liberalization has been the most dramatic, and arguably the most significant part of our economic reforms. Indeed, our external sector liberalization on Dr Manmohan Singh’s watch is the main motivation for this festschrift. Before 1991, India was one of the most closed economies in the world. Today, we are much more integrated, more integrated than we tend to acknowledge. How remarkable has this been? Let me cite just one contrast. Some 35 years ago, when I first went abroad, Indians could only carry $20. Now, every Indian can take out $200,000 every year.
It may be worthwhile in this context to take stock of the changes in the external sector since 1991. Since 1991, we have shifted from an administered to a largely market determined exchange rate; the rupee became convertible on the current account in 1994; there has been a sharp reduction in tariffs; QRs have been removed; export incentives have been phased out; we now have a deeper and more vibrant forex market and a host of forex derivative products.
The criticism, however, has been that after the burst of reforms in the 1990s, we have developed cold feet and have not moved further. I believe a more nuanced appreciation is necessary.
Our policy on external sector liberalization can be best understood in terms of the Impossible Trinity concept. The Impossible Trinity argument says that a country cannot simultaneously maintain all three policy goals of a fixed exchange rate, an open capital account, and an independent monetary policy.
In managing the choices under the Impossible Trinity, advanced economies have typically tended to give up on a fixed exchange rate. Over the last one year, Switzerland, to defend the Swiss Franc against appreciation, gave up on monetary policy independence in the bargain for a fixed exchange rate.
Where do we in India stand on the Impossible Trinity? Neither Keynes nor Friedman pronounced on it. So, we turned to the son of the soil - Gautam Buddha - and his celebrated Middle Path.
We let our exchange rate be largely market determined, but intervene in the market to smooth excess volatility and/or to prevent disruptions to macroeconomic stability. Our capital account is only partly open; while foreigners enjoy mostly unfettered access to our equity markets, access to debt markets is restricted; there are limits to how much resident corporates and individuals can take out for investment abroad, but the limits are quite liberal; and because of the liberalization on the exchange rate and capital account fronts, we may forfeit some monetary policy independence. What the middle solution also implies is that we have to guard on all the three fronts with relative emphasis across the three pillars, shifting according to our macroeconomic situation.
Those who contend that we have been too timid cite two somewhat inter-related arguments. The first argument is that we should move more rapidly and more decisively towards capital account because it would bring in more foreign savings for investment and growth and lower the costs of finance in the economy. It will infuse competition and generate efficiency gains, deepen the financial markets, and enforce macroeconomic discipline. The second argument is that the exchange rate should be fully floated and that RBI should foreswear from any intervention no matter what the circumstance. Exchange rate will then act as an equilibrating force, and RBI’s monetary policy will become more effective.
Admittedly, the arguments as I have stated above are extreme positions. Very few people take such extreme positions. Nevertheless, the extreme position provides a point of departure for making a case.
Let me now state where I stand on this. If you look around the world, there is no evidence that capital account convertibility, regardless of macroeconomic circumstances, has been a positive force. On the contrary, there is a lot of evidence to show that premature capital account liberalization can create macroeconomic imbalances with huge costs to growth and welfare.Striking examples are the Southern Cone countries in Latin America, the Asian crisis of the 1990s, Argentina, Turkey, Mexico, and more recently the global financial crisis when many countries came under stress because of too much liberalization, too fast.
Historical evidence shows that pre-mature capital account liberalization has turned economies into "high beta" economies by making them vulnerable to volatile external cycles, sharp fluctuation in exchange rates and asset price build up leading to bubbles.
In fact, the recent global financial crisis has been a clear turning point in the worldview on capital controls. Even the IMF has changed its orthodoxy. Before the crisis: the IMF view was that capital controls were inadvisable always and everywhere. After the crisis, the IMF has taken a more relaxed position, saying that there are certain 'circumstances in which capital controls can be a legitimate component of the policy response to surges in capital flows’. The World Bank and the Asian Development Bank Outlook - 2010 have also echoed these views
What is our policy on capital and liberalization?
- We are committed to opening up the capital account gradually along a road map, with the road map itself getting recalibrated on a dynamic basis.
- In calibrating our capital account liberalization, we need to balance the needs of the macro economy with the compulsions of macroeconomic and financial stability.
What are the preconditions for capital account convertibility? At the minimum, they are:
- Fiscal consolidation should be robust
- Financial sector should be more resilient
- Our export should become more competitive and our imports more price elastic
More liberal FDI policy with less of a bureaucratic interface would also make India a more friendly investment destination.

Conclusion
Let me now conclude. To fit with today’s context, I have raised the following two questions relating to India’s economic reforms and argued my position on both of them.
1. Why 2012 is not 1991?
2. Have we been too timid on external sector liberalization?
Before I leave the podium, I want to convey my best wishes to the Prime Minister for long life, health, happiness and fulfillment and every success in leading the nation.
My profound thanks to OUP and ICRIER for giving me this opportunity.